Mutual funds capital protection scheme aims at protecting the investors from losing their capital in volatile markets. Capital protection implies the net asset value should at least be equal to or greater than the face value of the fund on maturity. Generally, mutual funds are expected to maximise returns for investors through allocation of investments between risky and non-risky assets while protecting the original capital.

Typical types of mutual funds and unit trust in Ghana include:

Fixed income funds: These funds invest in longer-term fixed income securities such as bonds, notes, corporate debt, fixed-deposits, debentures and longer-term government securities. They may also include some money market instruments but largely do not include equities.

Money market funds: These funds invest in instruments (mostly loans) which mature within one year. These have low-risk, short-term securities such as treasury bills. It has a primary objective of protecting capital rather than seeking growth.

Equity funds: These funds invest mainly in equities (shares). These funds have long-term growth objectives.

Real estate investment trusts: These funds invest in real estate either private accommodation or commercial properties.

Balanced funds: These funds invest in mixture of fixed income, equity, money market instruments and any other strategies to try to achieve both growth and short-term protection of capital.

Ethical funds: These funds deliberately exclude certain industries and sectors (e.g alcohol, fossil fuel, tobacco) which for moral grounds are not invested into even if they stand to gain by investing in them.

Mutual funds capital protection rating

Mutual funds capital protection rating assesses the degree of certainty with which the portfolio structure is capable of achieving the objective of capital protection on maturity of the fund.

Typical fund structures

Fund structures can be broadly classified under two approaches (a) Static approach (b) Dynamic Approach.

Static Approach: This approach deploys basic strategy that guarantees capital protection at maturity, such that the present value of capital in fixed income instruments compounds to a level of protected capital at maturity, whiles the remaining amount is invested in risky assets to make a return.

Dynamic Approach: This approach deploys strategy that manoeuvres investment allocation between risky and non-risky assets, such that allocation towards risky assets increases when market conditions are ripe (offensive strategy), and it reduces, when market is deteriorating (defensive strategy). The test is, how effective should be the balance between offensive and defensive strategy to achieve capital protection objective.

Static approach 

Mutual fund capital protection rating adopts static hedge approach as a yardstick to measuring capital protection at maturity. This approach technically provides that large portion of portfolio is invested in debt instruments driven by:

(a) Amount of capital that needs to be protected – invested amount adjusted for expenses.

(b) Interest rate scenario – where interest rates are high, amount to be invested can be lower as the interest earned would be sufficient to adjust for any losses due to investment in equity.

(c) Fund maturity – funds that have longer maturity periods can allocate less to debt component and more to equity component, and shorter maturities will require a higher debt allocation.

(d) Credit quality of portfolio – where debt portfolio has higher credit quality, probability of loss is lower. Low credit quality has higher probability of loss.

The surplus amount post debt investments are usually invested in equity markets. The returns generated from equity allows for improving the returns earned from investments.

In forming an opinion on a fund’s relative certainty to provide capital protection, an assessment is made of market risk, credit risk, liquidity risk, quality risk and concentration risk to determine a gap risk, the risk that capital protection would not be met as per agreed terms on a particular date or on maturity. Market risk is the prime risk, which determines the fund’s capacity to meet the capital protection. This risk may be aggravated by other risks to reflect a cumulative effect of the risk appetite of the fund and its ability to meet capital protection.

Market risk arises when there is change in value of investments due to change in the market conditions. It may also arise when investments are not held to maturity. Market risk arises on account of:

• Interest rate risk: This refers to risk of variation in price of security due to change in interest rate. Fixed income investments are expected to be held till maturity to avoid reinvestment risk.
• Reinvestment risk: This refers to risk that interim coupons received from debt instrument may be reinvested at lower than original yield. Analysis of reinvestment risk is done to stress test the prevailing yield under various scenarios when inflows are reinvested at lower interest rate.
• Equity prices: Equity risk is probable loss arising from equity market fluctuations. Dynamic approach-based funds are comparatively more exposed to equity risk since these funds work on multiplier concept. Transaction cost of frequent rebalancing the portfolio may increase and could impact return on funds and ability to protect capital. Longer horizon exposes the fund to extra risk of delays especially when the multiplier is higher when portfolio rebalancing is done in changing market conditions. Risk appetite of fund depends on the nature of capital protection. Lower yield than projected in case there is a delay in deployment of funds, or debt instruments do not have the same maturity profile. Cushion for float risks may be built at the launch, maturity and during rebalancing of funds, while deciding the investment portfolio mix.

• Risk of loss arising from market fluctuations
• Risk exposure associated with floor
• Risk appetite (high or low)
• Transaction cost
• Delays between transaction
• Cushion for float risk
• Actual yield as against expected yield
• Multiples of cushion value (high or low)

Mutual funds are subject to default risk and downgrade risk of asset classes the fund invests in. The credit risk in mutual funds may be minimized by investing in asset classes with high credit quality. For mutual funds involving dynamic approach to capital protection, weighted average credit quality of portfolio is determined.

• Default risk of asset class
• Downgrade risk of asset class
• Credit quality of asset classes
• Weighted average of credit quality of portfolio

Marketability risk refers to the difficulty of selling or buying an investment. Some debt instruments are not actively traded in the secondary market, hence, may be difficult to offload and are characterized by a wider bid-ask spread. Also, in equity market some stocks are thinly traded and may entail high impact cost at the time of selling. For dynamic strategies, this risk becomes critical. Redemption management at the time of maturity of instrument is analysed.

• Marketability of instrument
• Ease of trading on instrument
• Time lag between trading on instruments
• Redemption strategy

Liquidity risks arises in case of large redemptions. While government securities and bank placements may be readily convertible into cash, other investments may take time. Investment types, structure and relative mix of investment are key in determining liquidity risk. Unit-holder concentration may signify the extent of redemptions in the fund. Liquidity risk may be mitigated by keeping credit lines to meet unexpected redemptions. Queue system in case of excessive redemptions may also help in managing this risk. An exit load may be imposed to discourage early redemptions – exit load would compensate for the impact cost. Minimum lock-in period clause for investment to ensure capital protection, along with imposition of back-end load in case of early redemption, may mitigate this risk.

• Structure of fund
• Investment type
• Relative mix of investment
• Unit-holder concentration
• Level of redemption
• Exit load on early redemption
• Minimum lock-in periods
• Back-end load on early redemption
• Credit lines to meet unexpected redemptions

The concentration risk in the portfolio is established by analysing the diversification across investment types and issuers. Fund portfolios are subject to additional risk when they are highly concentrated in a specific industry. 

Fixed income risk: Concentration in fixed income risk is assessed by determining the diversification across investment types, issuer, market segment, industry, or sector that could deviate from market trends.

• Philosophy of concentration risk 
• Ease of exit from market
• Minimum credit quality limits
• Credit concentration limits
• Maturity of instruments aligned with maturity of fund
• Concentration in security, issuer, market segment or sector
• Transition to high credit quality of corporate bonds
• Government bonds in market

Equity investment is measured by the exposure of single scrip and percentage of that scrip in the fund portfolio. The underlying objective is to evaluate whether the fund may be able to time its exit from the investment whenever needed. The overall equity allocation, multiplier and per scrip limits (% of free float) plays a pivotal role in the analysis of the fund’s exposure to equity risk.

• Concentration in sector limits
• Use of derivatives
• Volatility of returns on benchmark indices
• Liquidity situations
• Overall equity allocation in portfolio
• Equity multiplier
• Scrip limits as % of free float

Management quality is measured by the extent of management’s past experience, strategy, and future plans. Factors assessed include: 

• Related track record experience 
• Succession planning
• Employee relations
• Management risk mitigation plans
• Management’s past success in new projects
• Management stability and pro-activeness
• Capability of the second layer of management

Gap risk is the probability of gap event occurring, a situation when portfolio value falls below the floor and capital protection objective is violated. Gap event may be due to credit risk, reinvestment risk, market risk or liquidity risk. Value of gearing factor (multiplier) in dynamic strategy is determined through gap risk factors:

• Volatility of equity component – sudden fall in its value
• Simultaneous liquidity in debt and equity markets 
• Mitigation strategies to limit size of multiplier
• Monitoring volatility of equity component
• Monitoring credit risk of debt component

Float risk considers the opportunity costs, if funds are not deployed in a timely manner. Delayed deployment of funds may lead to investments being done at lower interest rates than originally planned.

Rating outlook assesses the potential direction of mutual funds’ capital protection over the intermediate term, typically over a one to two years’ period. Ratings from MF CP2 to MF CP5 may be modified by a positive (+) or negative (-) suffix to show its relative standing within the major rating categories.